Easy Money 101: What the Heck Is QE2, Anyway?

QE2. When I first heard this term, I knew it was not the ship, but I will admit some element of ignorance, perhaps perpetuated by a couple of glasses of wine at a business networking event.

From what I observed, I was not the only one somewhat mystified as both sides of Congress began the debate that intensified after last month’s mid-term elections. Each side has its reasons for being in favor of or against QE2. So, in our non-partisan way, here are both sides.

First, a definition. QE2 stands for quantitative easing, or, in layman’s lingo, the Federal Reserve’s (Fed) policy of increasing the money supply by purchasing U.S. government bonds from banks in open market transactions. The Fed wants ultimately to lower interest rates, with the hope that in doing so, consumers will be induced to spend, and investors persuaded to borrow money to expand their businesses or to invest in new plants, equipment, etc. (consumers could borrow, too, for that matter). When there are fewer bonds in the marketplace (because the Fed has purchased them and thus inserted lots of liquidity into the economy), the rates that bonds must pay to attract people to purchase them are pushed lower.

For any of you who may have forgotten Economics 101—here is how it works: when the Fed wants to ease, or flood the money supply, it buys bonds, forcing lots of liquidity into the system. This is known as an “accommodative policy.” Conversely, when the Fed needs a “tight policy,” (for example, when inflation looms), it decreases the money supply by selling bonds, and, therefore, takes money out of the system. (When the Fed sells bonds, we use our money to purchase them, effectively reducing the available money supply). The latter has not happened for a while, understandably.

The Fed’s rationale for QE2 is that if money floods the system, and rates go down even further, that people will start borrowing to invest and consume. On the other hand, some extremists believe that the government’s intervention caused the recession, and its policies have prolonged it. More of us middle-of-the-roaders believe there was plenty of blame to go around. What nearly everyone agrees on, it seems, is that people are not spending. If they have jobs, they are concerned about losing them. Or, that the economy is so sluggish they better hang on to all the cash they can sock away. If they don’t have jobs, there is no money to spend. So, will rock-bottom rates cause people to buy and invest? It’s a good question. And no one knows the answer.

By the way, we are not the only central bank that employs QE2 – just the most controversial, perhaps. Japan used it to defy domestic deflation in the early 2000s. The UK used it in 2008 to help ease its monetary crisis. The European Central Bank (ECB) has its rendition, as well, expanding the assets that banks can use as collateral in return for Euros.

Closer to home, the debate in Congress centers on what drives the differences in the two parties: Liberals believe we need to increase government spending to get the economy out of the doldrums; conservatives believe that we can get there by cutting taxes, thereby creating an environment in which businesses can spend on hiring, and reducing government spending. Both sides may have a point, since without the TARP bailout and extended unemployment benefits, the economy may have deteriorated even further (hard to imagine how it could, but I digress). On the other hand, 99 weeks of unemployment benefits that cost $100 billion has not moved the needle to get the unemployed back to work. There are still nearly 10 percent of the capable that cannot find jobs.

Where both sides agree, fortunately, is that unemployment is the single most important focus. So now that some common ground has been established, perhaps the partisan bickering can be set aside.

Larry McDonald, former Lehman Brothers bond trader and author of the best-selling A Colossal Failure of Common Sense, The Inside Story of the Collapse of Lehman, believes that a greater threat to the Fed’s accommodative strategy may lie in the internal disagreements within the Federal Open Markets Committee (FOMC) itself. The release of the Committee’s minutes last week, however, shows that, despite the governors’ lack of unanimity, the QE2 measure passed by a 10:1 vote. The minutes also indicate that the Committee is trying both to maintain price stability and maximize employment. That may be a hefty bite to chew. Finally, the minutes show that the Committee also downgraded expectations for economic growth in the process. Not exactly a rosy picture, but it’s done.

Time will tell whether the decision was the right one. The Chinese are upset, since making the dollar weaker (a logical byproduct of QE2) means we may not buy as much of their stuff. Germany does not like QE2, either, since they recall with horror what happened when their currency was devalued, setting the stage for World War II.

But, if flooding the system with money makes millions of Americans employed again, we will all be better for it. Employed workers pay taxes, buy goods and flood the economy with real dollars. Wouldn’t we all vote for that, no matter which side of the aisle we are on?

Chairman Bernanke is an expert on the Great Depression. Let’s hope those kudos extend to the Great Recession. This may be the last rabbit he can pull out of the hat.

Merry Sheils won the New York Press Club’s Journalism Award for best business writing in 2011 and 2012. As a portfolio manager for private clients, she writes a financial column for WomenAroundTown.com as well as features and profiles. She frequently writes economic and capital markets commentary, including white papers, thought leadership pieces and investment reports, for companies and investment managers. Prior to becoming a writer, Merry worked as a senior portfolio manager and investment analyst at BNYMellon and Wilmington Trust Company (now M&T Bank). A SUNY graduate with a degree in finance, she is the author of “Debt-Based Securities” and has been published in The Financial Times, Forbes and Chief Executive Magazine, and has appeared as a guest on CNBC. She founded First New York Equity, Incorporated, an investment advisory firm, and sold it to Price Waterhouse (now PricewaterhouseCoopers). She divides her time between New York City and her 18th century house in Columbia County, NY, where she is active in the North Chatham Free Library, the Old Chatham Hunt Club and the Columbia County Historical Society.